When it comes to accounting for operating leases, ASC 842 has imposed several new requirements that must be adhered to.
The FASB ASC 842 improves disclosure and transparency on the leasing liabilities of organizations of all types, including public and private ones. It is an effort towards boosting visibility in the financial statements reported by businesses.
One ought to be aware that leases now reflect on the balance sheet as a liability for the lease and an asset for the right to use the leased property.
Therefore, in this article, we will go through the primary requirements and steps to be followed while accounting for operating leases and making journal entries precisely, in accordance with ASC 842.
According to ASC 842, journal entries for operating leases are as follows:
It is necessary to have a solid understanding of the computations needed for these journal entries. Following the new standard, the calculation of a company's journal entries must begin with the creation of a lease amortization schedule.
Here are a few steps that must be followed, each of which is discussed with an example, to accurately submit ASC 842 journal entries and verify that the balance sheet numbers are precise.
Let's consider an operating lease on 1st January 2023 with the following initial values:
As a result, the new journal entries required by ASC 842 to recognize the lease commencement would look like the following:
The accounts for the ROU asset and lease liabilities now get included in the process of totaling the figures on the balance sheet.
Regardless of the recurrence of the reporting, one would see the following:
Note that this is based on the assumption that there have been no changes made to the entries. The handling of modifications is a different process, which is discussed later on.
These ASC 842 journal entries follow the format of monthly reporting because most firms use this frequency for their reporting schedule. The following would constitute the journal entries for January.
As a reflection of the payment made:
To take into account amortization:
To account for interest expenses:
The ROU value for January decreased as a result of amortization, and a rise in the value of the lease liability is reflected in the interest expense.
The company will keep posting journal entries at the reporting frequency that it has chosen until the time that the lease concludes, provided that there have been no modifications made to the lease agreement.
Following the posting of those journals, the lease liability and the right-of-use asset would get reduced to zero.
In case of a modification in the lease contract, the effective date of a modification requires accountants to review the value of ROU assets and lease liabilities.
Consider the following scenario: On July 15, one finds out that the monthly payments of $10,000 are going to increase to $12,000 starting August 1. A 6% increase has been applied to the discount rate modification.
Since this adjustment will have an effect on the company's prospective cash flow statement regarding the liability's current value, accountants will need to make an entry in the journal to reflect the re-measurement of this asset.
In the re-measurement journal entry, the following computation reflects the difference between these cash-paid amounts as a result of the re-measurement:
So, here is how the company would document July.
Reflecting July’s payment:
Representing the subsequent modification:
Representing interest expense:
The new adjusted payment schedule would be shown in August's journal entries as follows:
When reporting, the subsequent journal entries will follow the same line of logic as was used for reporting on previous months.
Also, it's crucial to keep in mind that there are modifications to these entries as the scope expands, even if this is a simple operation.
The operating lease journal entries would not adhere to the same reasoning as the original evaluation if the scope gets reduced.
The scope reduction is accounted for in subsequent processes. A lessee proposing a significant shift to the lease, such as deciding to rent out only 5 of 7 office spaces, is an illustration of a scope reduction.
ASC 842 includes new disclosure requirements to enable those who use financial statements to evaluate the amount, timing, and unpredictability of cash flows flowing from leases.
ASC 842 mandates that the reporting of operating lease liabilities as well as lease incentive prospects be included in the lease agreement. Disclosures regarding the operating activities encompass both quantitative and qualitative aspects.
The following provides an outline of accounting for operating leases following ASC 842 at a top standard.
Leases are required to be categorized in accordance with FASB standards.
To ensure adequate lessee and lessor accounting compliance, operating leases and capital leases were the two forms of leases recognized by the FASB ASC 840.
As a result of the implementation of ASC 842, capital leases were renamed finance leases.
An operating lease is considered to be an off-balance-sheet sheet transaction when ASC 840 is applied to it. In the income statement, the rent expense linked with the agreement is accounted for. There is no impact on the balance sheet.
However, in the case of ASC 842, upon the beginning of an operating lease, an ROU asset and an affiliated lease obligation must be recognized.
Accounting systems that have leases classified to be operational according to the FASB ASC 840 can keep the operating lease designation after the adoption of the ASC 842 standard. The FASB ASC 842 criteria must be followed by any leases entered into in the future.
To be more specific, the most notable change following the new criteria is that all leases (both operating and financing) have to be reported on the company's balance sheet. Journal entries are required to be made for operating leases following the FASB ASC 842 standards.
So, the real question that emerges is that when transitioning from ASC 840 to 842 compliance for the first time, what should the journal entries appear like?
Ideally, a company's ROU assets and lease liabilities should get reflected in its ASC 842 operating lease journal entries on the transition date if their accounting method accounts for leases by the date of commencement.
After that, utilizing accounting's best practices following ASC 842 will just be part of conducting business as routine.
While small-to-medium-sized businesses might be equipped to deal with the new guidance transition in spreadsheets, accounting for the adjustments posed by ASC 842 is significantly easier using lease accounting software.
Companies of a certain size should invest in a comprehensive lease accounting software solution to handle all of the company's leases with the help of AI-powered automation to ensure a degree of precision and speed that is unattainable by human means.
Accounting teams must give such solutions a try and figure out the best-fit option.